Key takeaways

• A US shareholder generally uses the asset method to apportion interest expense and uses the asset or modified gross income method to characterize an asset, the CFC stock, for the purpose of such apportionment.
• When the CFC elects to use the modified gross income method to apportion its interest expense the consistency rule requires that the US shareholder also use the modified gross income method to characterize the CFC stock for such purposes.

AptarGroup Inc. ("AptarGroup"), a US corporation, performed a restructuring in December 2014 whereby it transferred substantially all of its foreign subsidiaries to a holding company in Luxembourg ("Lux CFC"). AptarGroup claimed a USD 3.539 million foreign tax credit (FTC) for 2014, which the IRS denied in its entirety.

In more detail

At issue in the case was the amount of Lux CFC stock that should have been treated as a foreign source income producing asset for the purpose of apportioning AptarGroup's interest expense. This was important because the more of Lux CFC's stock treated as a foreign source asset, the more interest expense AptarGroup needed to apportion to AptarGroup's foreign source income. The more interest expense of AptarGroup apportioned to AptarGroup's foreign source income, the fewer FTC's AptarGroup was eligible to take in 2014 by operation of the FTC limitation under section 904(a).

Specifically, section 904(a) limits a taxpayer's eligibility to take FTC's for a taxable year based on the taxpayer's net foreign source income for such year. For this reason, expenditures of taxpayer allocated and apportioned to the taxpayer's gross foreign source income for a taxable year reduces the taxpayer's eligibility to take FTC's with respect to the taxable year.

A taxpayer's interest expense is allocated and apportioned under special rules which generally allocate interest expense to all of the taxpayer's gross income and apportion interest expense between categories of gross income (for example between foreign and US source gross income) under the asset method (i.e., based on the proportion of a taxpayer's assets that generate the different categories of income). A CFC of a taxpayer, however, can elect to apportion its interest expense (for example, for the purpose of determining net subpart F income) using either the asset method or the modified gross income method. Generally speaking, under the modified gross income method, the CFC apportions its interest expense in proportion to the relative amounts of gross income it earns in different income categories. When a CFC elects to use the asset or modified gross income method to apportion its interest expense, a consistency rule applies which requires that the same method of apportionment be employed by all CFCs in which a United States taxpayer and the members of its affiliated group constitute controlling United States shareholders. This consistency requirement is set forth in Treas. Reg. §1.861-9T(f)(3)(iv).

Apportionment of a CFC's interest expense is not the only process to which the asset method and modified gross income method are applicable. The two methods are also used to categorize the stock of a CFC when the CFC's US shareholder apportions its interest expense under the asset method. As noted above, unlike a CFC, a US taxpayer generally must use the asset method to apportion its interest expense. To illustrate (using a highly generalized example), consider: (i) a US shareholder that owns stock in a CFC, (ii) half the assets of the CFC produce US source income and half produce foreign source income, and (iii) the CFC's gross income is 75% foreign source and 25% US source. If the asset method is used to categorize the stock of the CFC, half of the stock of the CFC is a foreign source asset for the purpose apportioning the interest expense of the US shareholder. If the modified gross income method is used to categorize the stock of the CFC, 75% of the stock of the CFC is a foreign source asset for the purpose apportioning the interest expense of the US shareholder.

In AptarGroup Inc., Lux CFC elected to use the modified gross income method to apportion its interest expense, but AptarGroup used the asset method to characterize its stock in Lux CFC as a foreign and US source asset. Treas. Reg. §1.861-9T(f)(3)(iv) is discussed at length in the Tax Court's opinion. However, the case really has nothing to do with that consistency requirement, as it only applies to require consistency between different CFC's under common US control. The relevant rule, as identified by the Tax Court, is the flush language in Treas. Reg. § 1.861-12T(c)(3)(i), which states:

Stock in a CFC whose interest expense is apportioned on the basis of assets shall be characterized in the hands of its US shareholders under the asset method... Stock in a controlled foreign corporation whose interest expense is apportioned on the basis of gross income shall be characterized in the hands of its US shareholders under the gross income method...

Based on this rule, the Tax Court held that because Lux CFC elected to use the modified gross income method to apportion its interest expense, Lux CFC's US shareholder, AptarGroup, was obligated to use the modified gross income method to characterize the stock of the Lux CFC as a foreign source income producing asset and a US source income producing asset for the purpose of apportioning AptarGroup's interest expense.

Accordingly, the court granted the IRS partial summary judgment and held that AptarGroup must characterize its Lux CFC stock using the modified gross income method.